Credit ratings agencies’ credibility record is peppered with questions on methodology and bias

While credit ratings are now an integral component of the global financial market, the evidence about CRAs’ predictability and analytical credibility point towards prejudices against emerging market economies.

“National governments are the largest capital market borrowers and their credit standing serves as a key benchmark in the world’s capital markets. For investors, an accurate appreciation of sovereign default risk is critical — Moody’s rates the debt of over 120 sovereign nations, thus providing investors with a frame of reference that facilitates broad comparability amongst sovereigns,” so reads Moody’s “How Moody’s Rates Sovereigns and Supranational Entities”.

This, broadly, defines the contours of how Moody’s, the world’s first credit rating agency (CRA), goes about ranking governments’ ability to repay their debts on time. In an ideal scenario, such rankings should be derived from a statistically rigorous set of quantitative metrics, leaving as little as possible to ambiguous approximations and commentaries. In the real world, however, the explanations leave a lot of room for opaqueness and gaps in information processing. There is a current context to this involving India. On August 18, Moody's Investors Service affirmed its Baa3 rating on India and maintained the stable outlook, but warned of political issues and even cited the example of the ongoing violence in Manipur.

While the Baa3 affirmation, in itself, may have been drawn upon through a rigorous process, the phraseology in the accompanying commentary and the annotations is where hypotheses need further buttressing to remove elements of bias. In the statement, Moody’s said that "…the curtailment of civil society and political dissent, compounded by rising sectarian tensions, support a weaker assessment of political risk and the quality of institutions,” using the “eruption of unrest in the north-eastern state of Manipur” as an illustration of susceptibility to political risk.

While credit ratings, despite design and data interpretation flaws, are now an integral component of the global financial market where billions of dollars move across geographies at the click of a computer key, the evidence about CRAs’ predictability and analytical credibility point towards prejudices against emerging market economies. To be sure, there is now a wide body of credible academic literature, where economists and researchers have spared no punches on how CRAs have demonstrated a distinct bias against emerging economies on sovereign rating commentaries on a comparable scale of metrics placed against the so-called developed countries.

“There is discontentment with the basic characteristics of the rating process applied by the CRAs. First of all, the SCRs published by different CRAs appear as an output of a black box that is unknown to both issuers and investors. The CRAs assert that beyond their quantitative analyses, specific attention is given to qualitative factors, such as political factors and projections. All in all, the process of assigning a credit rating is allegedly opaque…the system of assigning a sovereign credit rating seems to be reductionist and over-simplistic,” Derya Gültekin-Karakaş, Mehtap Hisarciklilar & Hüseyin Öztürk said in a 2011 paper entitled Sovereign risk ratings: Biased toward developed countries?.

In the current context, it may be pertinent to ask what is the information and data matrix that Moody’s has gathered and processed regarding the events in Manipur to prompt rising political risks in India. This is a valid question to raise because data and information are the very edifices on which the architecture of any ratings action and annotation should rest.

A paper, Default, Currency Crises, and Sovereign Credit Ratings, by Carmen M Reinhart in World Bank Economic Review, presents evidence that Moody’s ratings show a gulf between emerging markets and developed economies. In an oblique reference to a possible bias in commentary and observations, Reinhart noted that “the Moody’s ratings at the outset of a currency crisis are significantly lower for emerging market economies — on average, about a third that for developed economies. Again, the downgrade for emerging market economies (about 9 percent) is far greater than that for developed economies (less than 1 percent). But the probability of a downgrade — and the probability of multiple downgrades — in the 12 months following a crisis are significantly higher for emerging market economies in the case of Moody’s sovereign ratings.”

Simply put, this implies that Moody’s possibly could be looking at emerging market economies (EMEs) and developed economies through two different sets of lenses while assessing sovereign rating actions. This does not augur well for the CRAs’ credibility if the statistical and analytical standards for assessing economic and investment conditions have been called out for prejudices against EMEs. Others have also flagged allegations that some CRAs have regional bias and that certain CRAs favour particular regions. NU Haque, N Mark, and Donald Mathieson, in their 1997 paper Rating the Raters of Country Creditworthiness, note that Euromoney usually gives higher credit ratings to Asian and European countries than Latin or Caribbean countries, while Institutional Investor is more generous to Asian and European countries than to African countries. David F Tennant and Marlon R Tracey in their paper Are Poorer Countries Disadvantaged by the CRAs? Empirically Establishing a Bias echoed similar views, demonstrating the existence of bias against developing countries in ratings agencies’ commentaries.

“Our results provide clear empirical evidence of the existence of bias. The results indicate that S&P, Moody’s and Fitch all find it more difficult to upgrade poor countries relative to rich countries, for any given improvement in ability and willingness to repay debts. These results are taken as a strong indication of bias,” Tennant and Tracey said in their paper. The role of CRAs in the Asian currency crisis during the late 1990s remains a case in point. The CRAs were conspicuous among the many who failed to predict the crisis. G Ferri, L-G Liu and JE Stiglitz, in a 1999 paper “The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis”, suggested that CRAs aggravated the East Asian crisis by first failing to predict its emergence and thereafter becoming excessively conservative. CRAs downgraded East Asian crisis countries more than what would have been justified by these countries’ worsening economic fundamentals. This adversely affected the supply of international capital to these countries.

A lot is dependent on CRAs in the world of international finance, global macroeconomics and transnational investment. Political risk assessment in a country as complex as India, which, many, including Moody’s, believe will remain the primary engine for global growth, should be subjected to thoroughness and exactitude based on transparency, which will require going much beyond an uncorroborated commentary.